Within bonds, favor credit over duration
While bonds remain expensive, it’s important to have some exposure to fixed income. Given that rate volatility will likely remain elevated in coming months, investors may want to look to the high yield sector, which is typically less sensitive to rate movements than other fixed income sectors. We also like tax-exempt municipal bonds, which currently offer attractive yields.
Look for tactical opportunities within fixed income
Income seekers must keep in mind that rates around most of the world will remain low for some time despite any Fed action, so flexibility and selectivity are critical in fixed income asset allocation.
Market Realist – Favor credit over duration as interest rates rise.
While bonds will likely underperform stocks for the remainder of the year and possibly beyond 2015, certain segments offer value. As we mentioned earlier, Treasuries (TLT) and investment-grade corporate bonds are currently yielding much lower than their long-term average. Higher interest rates are typically a negative for these sectors. However, long-dated Treasury yields may not rise to a great extent due to the lack of supply and high international demand.
During the last period of rising rates, from December 2008 through June 2009, yields on ten-year US Treasuries increased from 2.08% to 3.95%. Credit spreads also tightened, with investment-grade (LQD) spreads declining from 5.9% to 3.2% and high yield spreads declining from 19.0% to 9.2%.
The returns for the iShares Barclays 7–10 Year Treasury Bond ETF (IEF), LQD, and the SPDR Barclays Capital High Yield Bond ETF (JNK) between December 2008 and June 2009 were -10.2%, 0.7%, and 32.3%, respectively.
While higher interest rates have proven to be a headwind for stocks and investment-grade bonds this year, high-yield bonds (HYG) have done relatively well year-to-date and over the last period of rising rates. High-yield bonds appear relatively attractive.
The 30-year municipal bond is currently offering 3.4% compared to the 3.1% of a Treasury with the same maturity. Municipal bonds do offer decent yields for yield-hungry investors, especially for investors among the highest tax bracket.